Algora myths of the free market phần 5 pot

The Virtual Reality of Classical Economics was only with government intervention in the mid-to-late nineteenth century that quality of life improved beyond that of the fifteenth century Laissez faire has not provided a service to this country or to any other The fact that state-planned communism is disastrous does not support the opposite extreme, pure free market economics Neither does the fact that free market economics is amenable to strict mathematical modeling, given that the models bear so little resemblance to reality Free market economics has been appealing to us — just as it was previously appealing to the Dutch and the English — because it provides an advantage to the economically dominant player This is true not only in international trade, but also in the domestic arena Capital has inherent advantages and naturally wishes to protect and extend those advantages But those advantages bear the seeds of their own destruction Without intervention to protect the middle and lower classes, a free market economy can drain money from those classes to create an extreme concentration of wealth Historically, such a concentration of wealth has destabilized societies and adversely impacted the security and standard of living of even the wealthy This has happened again and again Unless we remove the blinders of classical economic theory and open our eyes to this historic pattern, it will happen yet again 97 A NEW ECONOMIC PARADIGM AN ALTERNATIVE APPROACH Free markets have played an important role They have provided incentives for innovation and for low-cost production of desirable products They have enforced pragmatism at the expense of ideology They have facilitated exchange and provided a working definition of fair price Attempts made to replace them, typically by government management, have come to naught But there is a wide gap between the practical efficacy of free markets and the claims that laissez faire necessarily maximizes the wealth of society and that interference is never warranted It is these more ambitious claims that support the doctrine of government non-intervention It is these claims that embody what John Kenneth Galbraith calls “theological laissez faire.” While classical economists may summarily dismiss “theological laissez faire” as a grotesque caricature, theologians have a better handle on the issue Harvey Cox, a professor of divinity at Harvard, has fleshed out theological laissez faire in some detail: The lexicon of The Wall Street Journal and the business sections of Time and Newsweek turned out to bear a striking resemblance to Genesis, the Epistle to the Romans, and Saint Augustine’s City of God.… There were even sacraments to convey salvific power to the lost, a calendar of entrepreneurial saints, and what theologians call an “eschatology”… I saw that in fact there lies embedded in the business pages an entire theology, which is comparable in scope if not in profundity to that of Thomas Aquinas or Karl Barth As I tried to follow the arguments and explanation of 99 Myths of the Free Market the economist-theologians who justify The Market’s ways to men, I spotted the same dialectics I have grown fond of in the many years I have pondered the Thomists, the Calvinists, and the various schools of modern religious thought (“The Market as God,” The Atlantic Monthly, March 1999, p 18f) In the spirit of ecumenism, it has become fashionable to cite the relevance of Zen to investing One author claims, seriously, that day trading requires “… a certain wisdom, a Zen-like sense of … insignificance in the face of the Market.” (Millman, The Day Trader, p 25.) The diversity of failures of the free market should suffice to reject theological laissez faire Flaws are plentiful Economists without blindfolds have ably addressed its preoccupation with the short term “[I]n an era of man-made brainpower industries, capitalism is going to need some very long-run communal investments in research and development, education, and infrastructure Yet when capitalism’s normal decision-making processes are used, capitalism never looks more than eight to ten years into the future and usually looks only three to four years ahead The problem is simply put Capitalism desperately needs what its own internal logic says it does not have to do.” (Lester Thurow, The Future of Capitalism, p 16.) Although it has received the most attention, laissez faire’s propensity to imperil long-term prospects in order to satisfy the short term is not its only failing The very structure of laissez faire is incompatible with wealth-maximizing institutions like patent protection This structure renders laissez faire incapable in principle of achieving its own wealth-maximizing ends Independently, the picture of economies and financial markets painted by laissez faire is far removed from any school of realism Contrary to that picture, economies are not comprised of entrepreneurs competing against each other on a flat playing field They are oligopolies in which powerful economic interests purchase and wield significant political power Also contrary to that picture, prices not tend to a stable unchanging equilibrium And economic differences not disappear Once they reach a certain size, feed on themselves The tendency of differences to feed on themselves is common and is not limited to economies If neighboring countries have comparable military strengths there is little incentive for one to attack another The cost of a war is too great, as is the risk of losing But as military differences increase beyond a certain threshold the risk-reward ratio changes It may now make sense for a stronger country to invade a weaker neighbor By assimilating the resources of 100 A New Economic Paradigm the weaker state the stronger can increase its own strength and can gobble up its neighbors one by one This underlies the notion of balance of power Military equilibrium is not stable It requires deliberate action by governments to build alliances that maintain a military balance sufficiently close to equilibrium to deter aggression Just as it may be appropriate to intervene to maintain a balance of military power, there may be reason to intervene to maintain a balance of economic power Without the moderation of extreme economic disparity society has repeatedly inclined to increasing violence that triggered instability and led to a lower standard of living for all Historically, such moderation has been achieved by massive disaster that decimated the non-wealthy and so increased their economic power Government intervention to maintain a balance of economic power would be less painful It would increase the long-term wealth of nations Laissez faire misses all of this No wonder it has underperformed Yet despite its palpable flaws laissez faire is flourishing as if there were no conceivable alternative Why? Widely accepted theories are truly the undead Not even the most powerful contrary evidence can kill them Even in physics the Rutherford model of the atom was universally accepted, despite its obvious flaws, until quantum theory Only a better theory can dispatch an accepted theory This is so in all sciences, including economics To be effective, a criticism of laissez faire must present a realistic alternative The ideal would be a theory that has already been successfully applied to structures as complex as economies Enter nonlinear thermodynamics This theory, a recent branch of physics, is the most general theory dealing with complex systems open to exchange matter and/or energy with their environment It explains a variety of chemical and biological behaviors Its significance has been enhanced by the awareness that ordinary dynamics is limited in the range of phenomena it can predict In order to predict behavior in any science, it is necessary that the evolution of systems be insensitive to sufficiently small differences in initial conditions Otherwise, apparently identical systems can evolve along different paths and we cannot predict how a system will evolve Classical dynamics fails this test Even simple systems that are virtually identical can quickly diverge in their behavior “Richter kept clamped to his windowsill a well-oiled double pendulum.… From time to time he would set it spinning in chaotic nonrhythms that he could emulate on a computer as well 101 Myths of the Free Market The dependence on initial conditions was so sensitive that the gravitational pull of a single raindrop a mile away mixed up the motion within fifty or sixty revolutions, about two minutes.” (James Gleick, Chaos, p 230.) As systems become more complex, dynamic predictability, based on the positions and momenta of their component particles, breaks down completely Near-infinite sensitivity to dynamic initial conditions precludes their use as a predictive tool Because of this sensitivity, dynamics cannot directly predict the behavior of complex systems But for certain kinds of systems this extreme sensitivity to dynamic variables is balanced by decreasing sensitivity to thermodynamic variables: temperature, pressure, chemical potential This allows for successful prediction in terms of thermodynamic variables That is the rationale for the autonomous science of thermodynamics But there are limitations to even thermodynamic description Life appears to transcend the laws of thermodynamics The development of organisms and the evolution of species are characterized by increasing order This cannot be explained within classical thermodynamics, for it appears to violate the second law of thermodynamics That law identifies thermodynamic equilibrium as a state of maximum entropy (disorder) As a system approaches equilibrium its entropy increases, its internal disorder increases, its internal order dissipates (A bathtub may start with hot water on one side and cold water on the other After time the water will mix and it will all be lukewarm The spatial hot-cold order will dissipate.) Increasing internal order, apparently forbidden by the second law, has long been a source of conflict between biology and physics Biologists, especially embryologists, faced with the palpable reality of the development of finely-tuned organs, skeletons, and nervous systems in living organisms, saw a need to circumvent the second law of thermodynamics This led to vitalism, theories that living systems are characterized by some unique quality, Driesch’s entelechy (a mysterious whole-making factor that drives biological organisms toward some predetermined end) or Bergson’s élan original de la vie This enables them to evolve contrary to the second law of thermodynamics, to generate and sustain a natural internal order In fact, mysterious qualities like entelechy are not necessary Nonlinear thermodynamics can explain the development of order without the need to postulate anything new Indeed, the ability to develop and sustain a natural order is not limited to living organisms Even though they have not generated the 102 A New Economic Paradigm attention associated with order-creating biological processes, a number of chemical and thermodynamic processes are characterized by the spontaneous generation and sustenance of macroscopic order These processes occur in systems that are open to exchange energy with their environment, that are far from internal equilibrium, and whose evolution can be described by nonlinear differential equations with positive feedback Simply, they occur in systems with characteristics similar to living organisms — and economies While such systems produce entropy in accord with the second law of thermodynamics, they can export more entropy across their open boundaries than they produce As their remaining entropy decreases, their internal order increases At the microscopic level, these systems are characterized by the mutual interdependence of their components and, under certain conditions, by a high degree of sensitivity to internal fluctuations and to small changes in their environment The order that evolves is typically cyclic The simplest example is Bénard instability, in which a thin layer of liquid is heated from below Up to a critical temperature gradient, the heat is dissipated by conduction But at steeper temperature gradients, sufficiently far from the internal equilibrium of uniform temperature, a new phenomenon appears The heat is dissipated more efficiently in hexagonal convection cells (boiling) in which large numbers of neighboring molecules no longer act independently but move in the same direction over macroscopic distances Nonlinear thermodynamics explains not only Bénard instability, but also the generation of structures and cycles in a variety of chemical and biological processes It shows that these processes are compatible with the laws of physics, indeed, that they can be explained by physics Economies bear striking similarities to these systems Economies, like chemical and biological structures, are open systems, often far from internal equilibrium Their evolution can be described by nonlinear differential equations Economies also have well-recognized positive feedback mechanisms Not only is their underlying mathematical description similar to that of nonlinear chemical and biological systems, but their behavior is similar Economies, like living organisms, are characterized by stable cycles and by occasional hypersensitivity to the smallest changes in their environment Even though nonlinear thermodynamics has not yet been applied to economics, it could plausibly provide insight into economic structures and processes In any case, its success in explaining the behavior of complex systems 103 Myths of the Free Market in other sciences dispels the Newtonian notion that it is always natural for the components of a system to be mutually independent At least in thermodynamics, chemistry and biology there is a range of conditions under which a system’s components naturally exhibit mutual interdependence In transcending the Newtonian paradigm of independent billiard balls, the success of nonlinear explanations undermines the starting point of Adam Smith, that economic behavior can be best understood in terms of individuals acting independently to secure their own immediate economic advantage It reinforces elements of modern psychology and sociology, as well as common observation, that contradict the classical view In fairness to Adam Smith, survival has always been an important motivator In the early days of the Industrial Revolution when there was no social safety net, when many died of starvation and many more from malnutrition-related illness, economic success was a critical component of survival itself The role of economic success was understood by everyone and naturally became central to people’s psyche It is understandable that individuals engaged in such a battle for survival should focus on their immediate economic welfare In the days since Adam Smith, however, modern industrialized countries have woven social safety nets — in defiance of the spirit of laissez faire These have distanced economic performance from survival Consequently, the role of economic success as a motivator has declined Concerns with other matters have come to play a greater role The desire to create value has led otherwise rational individuals to accept jobs that may not be in their best short-term economic interest (Médecins sans frontières) A sense of family has induced wives and mothers to accept less income in order to stay home and bring up their children People have refused higherpaying jobs rather than relocating and leaving community and friends Employees have chosen early retirement because they value leisure more than the economic benefit of continuing to work Surveys show that a substantial majority of families would happily relinquish some income for more family time These behaviors illustrate the unreality of the laissez faire picture of independent individuals working solely for their immediate economic gain Of course, much of this would not have been true in the days of Adam Smith But the world has changed since then It is only our economic paradigm that has not changed 104 A New Economic Paradigm Ironically, devotees of laissez faire fail to realize how marginal is the role played by the theory’s premises The assumptions: • individuals naturally work only for their own immediate economic gain; and • under these conditions the invisible hand of the free market maximizes total wealth; rarely, if ever, enter into economic calculations They could be dropped and few but ideologues would notice Their replacement by nonlinear thermodynamics would be a boon, freeing us from the doctrinal orthodoxy of theological laissez faire For while the nonlinear paradigm is compatible with free markets, it does not pretend that a pure free market economy will necessarily produce the best possible results Also, because nonlinearity involves the mutual interdependence of a system’s micro-components, it is open to considerations of social responsibility that have been characteristic of democratic thought since ancient Greece (This is not meant to attribute consciousness or responsibility to a system’s micro-components It merely shows mutual independence is not necessarily natural, even in the world of physics.) NONLINEAR THERMODYNAMICS AND ECONOMICS Nonlinear thermodynamics was developed by Ilya Prigogine, for which he was awarded the Nobel Prize in chemistry in 1974 This theory, an extension of classical thermodynamics beyond its traditional limits, has important ramifications for physics, chemistry and biology — and, perhaps, economics The subject matter of classical thermodynamics is the quiescent behavior of systems near thermodynamic equilibrium Thermodynamic equilibrium is characterized by homogeneity: uniform temperature, pressure and chemical potentials Near-equilibrium states are characterized by small differences in these parameters For many thermodynamic and chemical systems, it is possible to calculate the conditions for equilibrium and their behavior near equilibrium The equations describing such systems are a standard part of physics curricula But some of the most interesting thermodynamic behavior occurs in open systems far from equilibrium This cannot be understood in terms of classical thermodynamics Turbulence and convection are common examples of far-fromequilibrium behavior that lie beyond classical thermodynamics To be alive an organism, an organ, or even a cell, must be far from internal equilibrium, from 105 Myths of the Free Market homogeneity Common processes in chemistry and biology that are characterized by stable cycles take place in open systems far from equilibrium These systems and the behaviors peculiar to them are the subject matter of nonlinear thermodynamics They are characterized by a principle of selforganization As they evolve they generate new and stable internal orders that can sustain themselves even in the face of changes in their environments The simplest and purely thermodynamic example is Bénard instability, in which neighboring molecules “cooperate,” moving in the same direction at the same time over considerable distances to dissipate heat in macroscopic hexagonal convection cells At a greater level of complexity nonlinear thermodynamics explains oxidation and reduction cycles in chemistry At still greater levels of complexity, large molecules form templates for their own reproduction Manfred Eigen and Peter Schuster incorporated this into an explanation of the evolution of life, an explanation far more plausible than small molecules coming together in random interactions to form macro-molecules In Eigen and Schuster’s view, there is a positive feedback reaction in which molecules form templates for the production of other molecules Nucleotides produce proteins, which in turn produce more nucleotides (Naturwissenschaften, 1978, p 341f.) A system will generate nonlinear behavior only if: (i) It is open, able to exchange matter and/or energy with its environment (ii) Its evolution can be described by non-linear differential equations (iii) The equations describing its evolution allow for positive feedback (iv) It is sufficiently far from internal equilibrium Under these conditions microscopic fluctuations within the system may not be suppressed, but may be amplified to the point that they bring a new macroscopic order to the system, an order that is typically cyclic Economies satisfy these conditions: (i) They are open and exchange matter and energy with their environment (e.g trade) (ii) Their evolution can be described by nonlinear differential equations (iii) They commonly exhibit positive feedback Higher inflation → higher inflation expectations → a propensity to spend faster, before prices rise further → a higher velocity of money → still higher inflation… (iv) They are often removed from internal equilibrium With respect to the distribution of wealth, the more wealth concentrates in fewer hands, the further removed is the economy from internal equilibrium 106 A New Economic Paradigm orders, to buy a stock once it advances beyond a given price or to sell a stock once it declines below a given price.) This is what happened in the oil price crash of 1985 and the stock market crash of 1987 Potential buyers disappeared when — and because — prices plunged These may seem to be isolated occurrences In fact, this type of behavior is more common than many suppose, and it plays an important role in financial markets The rapidity of the rise in stock prices can cause investor mania and become a primary motivation for new buying These new investors, previously afraid to buy at lower prices, are now afraid of being left behind, of missing easy and automatic appreciation (How many individuals who would not touch a stock or mutual fund in the early 1980s invested heavily in the late 1990s, after stocks, mutual funds, and market averages had appreciated more than ten-fold?) In market panics, the severity of the price decline scares investors — who would not sell earlier at higher prices — into dumping their positions Margin debt introduces a feedback mechanism that amplifies the decline: the lower stock prices go, the more margin calls go out, the more margin debt must be liquidated, the more stock must be sold, the lower stock prices go The same feedback mechanisms that cause euphoria and crashes contribute to normal market cyclicality Momentum investing is common even in normal times, and from investors who are unaware that they are momentum investors The longer a stock performs well, the greater is the confidence of investors that it will continue to perform well The price advance itself generates new buying as investors, concerned about risk at a lower price, become increasingly comfortable as, and because, the price moves up Momentum buying, feeding on itself, carries the price beyond a reasonable level and sets up the next decline The decline is a mirror image of the previous advance, in which momentum investors sell the stock primarily because it is declining In their haste to get out, they sell it at a price below a reasonable level, setting up the next advance There is also long-term positive feedback between financial markets and the economy In a secular bull market, investors’ wealth increases as their stocks appreciate Their additional wealth increases their comfort in spending more The wealth effect stimulates the economy and leads to higher corporate profits Higher profits support higher stock valuations, which further increase investors’ wealth, leading to even more spending In a secular bear market just the opposite 109 Myths of the Free Market occurs This feedback increases the amplitude of long-term economic and financial cycles So much for a self-correcting market! There are similar feedback mechanisms within industry The ethical drug sector has consistently provided an above-average return on equity and aboveaverage growth combined with below-average risk According to classical economics, such an industry should attract sufficient capital to foster enough competition to reduce its return on equity to the average Yet these superior returns have persisted for more than half a century, the result of another positive feedback cycle Researchers, marketers, etc are attracted to the top industry, which can choose the best of them Their contributions allow this industry to continue to outpace others These examples illustrate a major difference between a nonlinear worldview and that of classical economics In nonlinear systems cycles and nonuniformities are natural, requiring no special explanation By contrast, classical economics regards a uniform unchanging steady state as natural Cycles and non-uniformities are deviant and require special explanation It is a weakness of the classical view that even ingenious attempts to explain standard nonlinear behavior appear forced Traditional economic theory has been handicapped by the need for assumptions that are mathematically tractable within its paradigm The nonlinear paradigm has an important advantage in this respect The conditions necessary to nonlinearity — open systems, far from internal equilibrium, whose evolution can be described by nonlinear differential equations in which there is positive feedback — are more realistic than those necessary to classical economics What are the ramifications of an economic theory based on nonlinear thermodynamics, as opposed to one based on laissez faire? An immediate effect is to free us from the laissez faire conception of people as interested only in their own immediate economic welfare This conception conflicts not only with our own experience, but also with traditional views Aristotle regarded people as by nature political animals who understand that they not live in a vacuum, but that their own well-being and security depend on the well-being of their community In contrast to laissez faire, in a world characterized by nonlinearity independent action will be natural under certain conditions while mutual cooperation will be natural under other conditions This lies closer to the view of the classical Greeks, and also to common sense 110 A New Economic Paradigm At a more practical level, laissez faire sees natural economic forces as purely benign, leading to and maintaining a stable wealth-maximizing equilibrium Any interference with those forces can only diminish total wealth By contrast, nonlinear steady states may be unstable and natural forces may lead systems away from equilibrium There is no assurance that this process is benign To the contrary, there is historical evidence that it can lead to disaster It may be appropriate to intervene to mitigate the effects of these forces This is not intended to imply that a nonlinear approach is incompatible with free markets It is incompatible with theological laissez faire, with the doctrine that any interference whatsoever with the free market must diminish economic performance But it fits with the unfettered operation of the market within a broad range (It may be reasonable to extend a nonlinear approach beyond economics The flow of history resembles nonlinear systems in its cyclicality Historians from Arthur Schlesinger to Jose Ortega y Gassett, from Arnold Toynbee to George Modelski, have argued for the importance of cycles in history William Strauss and Neil Howe (Generations, The Fourth Turning) claim that generations at similar phases of different historical cycles have the same worldviews and the same collective personalities Independently, there are times that the direction of history can be highly sensitive to minor events, a typical feature of nonlinear systems How would the world be different if the field of battle at Waterloo had been dry? What if Marx had had the money to leave England for the U.S.? Perhaps there are similar sensitivities in individual lives “There is a tide in the lives of men, which, taken at the flood, leads on to fortune; omitted, all the voyage of their life is bound in shallows…” (Shakespeare, Julius Caesar) While history cannot be described in terms of differential equations, nonlinear thermodynamics at least suggests analogous mechanisms for historical patterns of structure and change.) The most important implications of nonlinearity for the present U.S economy are based on the feature that once a nonlinear system crosses a critical level, called a bifurcation point, there are new solutions to the differential equations describing its evolution These solutions entail new and different behavior Rules that had previously predicted behavior no longer apply Forces that had previously been applied with success to change the behavior of the system no longer work A system that had been controlled by these forces may spiral out of control 111 Myths of the Free Market Presently, evidence supports the conjecture that in our record stock market valuation and our record debt, both surpassing the previous records made in 1929, we have crossed important bifurcation points The positive feedback loops characterizing the unwinding of this state express themselves in vicious circles leading to a downward economic spiral: Decreased Investor Confidence Decreased Investor Wealth Decline in Stock Prices Decreased Investor Spending Lower GNP, Lower Earnings Flow of Funds away from Stocks Lower Fair Value of Stocks This sort of cycle is not just a twentieth-century phenomenon The bursting of speculative bubbles in 1837, 1857, 1873, and 1893, bubbles incubated by the new technology of railroads, led to stock market declines of 50% or more All of these declines touched off economic contractions There is no reason to think things are different today The annual rate of change in the S&P Composite is the single most accurate of the Commerce Department’s leading indicators This suggests that the wealth effect may have a consistent effect on spending and GNP If the bursting of our technology-financial bubble were to cause similar behavior, how severe could this downward spiral be? At its high in 1929, stock market capitalization reached 80% of GNP From 1929 to 1932 the stock market lost nearly 90% of its value The capital loss was 70% of GNP The concomitant 112 A New Economic Paradigm contraction in real GNP was 30% At its 2000 peak, stock market capitalization was 180% of GNP A 60% decline in market value would correspond to a capital loss of 108% of GNP, almost 50% higher than the loss following the 1929 peak If the ratios remain the same, this would suggest a nearly 50% decline in our real GNP Is a 60% stock market decline likely? Unfortunately, it could easily be greater The only historical parallel with a stock market as overvalued as our current market was 1929, which resulted in a 90% decline Even our 1973 bear market, in which stocks were not so overvalued and in which the financial bubble was far smaller, saw a decline of 60% Independently, a drop in the average price-to-sales ratio or the price-to-dividend ratio to their average values over the past 50 years would result in at least a 60% market decline Is it likely that we will have the same ratio between the loss of financial wealth and the loss of GNP? Some measures suggest the ratio could be larger In 1929, only the wealthiest owned stocks Many of these individuals did not change their spending habits as a result of the stock losses Now, half of us own stocks It is plausible that a sharp market decline would affect more people and result in a more widespread curtailment of spending In addition, our personal financial leverage is greater than it was in 1929, suggesting that a financial loss would have a greater impact There are some positives as well; though it is not likely that they could save the day The Federal Reserve has the ability to increase money supply and lower short-term interest rates, which should stimulate the economy In 2001, the Federal Reserve eased aggressively, lowering short-term interest rates 11 times, to a multi-decade low Ominously, that is the first time since the Great Depression that repeatedly lowering the discount rate did not give the economy an immediate boost, and also the first time that such action left the stock market lower than it was when the Fed began easing This suggests that something is different now If, in fact, we have crossed a bifurcation point as we had in 1929, if the economy is sufficiently out of balance, then one might expect Federal Reserve actions to be ineffective And with the discount rate below 2%, the Fed is dangerously low on ammunition (In addition, excessive monetary stimulus could endanger our currency Worries about a collapse of the dollar could restrain monetary stimulus.) A factor more likely to cushion our economy may be that in an economic contraction we would import less Our balance of trade would improve, slowing 113 Myths of the Free Market our economic decline, albeit at the expense of our trading partners But this would be a relatively small effect All in all, it would be foolish to assume that some ineffable and infallible invisible hand will protect our economy from a severe contraction It would be imprudent to neglect the very real possibility of economic catastrophe Unfortunately, the effects of such a catastrophe could extend beyond the economy It is possible that we have crossed yet another bifurcation point, a transition that could make matters even worse For we now have a record economic inequality between the rich and the rest Historically, extreme levels of economic inequality have uniformly led to an unraveling of the social fabric For the first time in history we may be aware of this pattern Hopefully, we will act wisely on the basis of such awareness If we fail to so, I fear it is likely that we shall experience yet another round of increasing violence, widespread decline in the quality of life for all, and a potential breakdown of our political and social systems 114 APPENDIX NONLINEAR ECONOMICS Nonlinear processes can be described by sets of differential equations The solutions to these equations describe behavior that is typically cyclic The purpose of this appendix is to illustrate the nature of these equations and their solutions The discussion is simplified in that quantitative assumptions have been chosen to make the mathematics easier Despite the simplification, the examples illustrate nonlinear themes and their relevance to economics (The mathematics underlying these examples and the physical chemistry paralleling them are lucidly discussed in Ilya Prigogine’s From Being to Becoming, chapters 4-6.) In the first example, consider the evolution of two variables: inflation (I) and unemployment (U) If there is no unemployment, workers will have leverage with respect to their wages Wages and inflation will chase each other, causing inflation to accelerate Assume, as suggested by scale invariance, the rate of increase of inflation is proportional to the rate of inflation (1) dI/dt = k1I (k1 > 0) If there is unemployment, there will be less upward pressure on wages and also less demand, so there will be less inflation pressure The higher the unemployment, the smaller the acceleration in inflation, and for sufficiently high unemployment, inflation will decelerate Assume the relation is linear (2) dI/dt = k1I(1 – k2U) = k1I – k1 k2IU 115 Myths of the Free Market Now, consider unemployment If there is no inflation, fiscal and monetary stimulus should reduce unemployment Assume the decrease in unemployment is proportional to the level of unemployment (3) dU/dt = – k3U (k3 > 0) If there is inflation economic stimulus will be restrained by the fear of accelerating inflation The higher the inflation, the more restrained will be the monetary and fiscal policy and the less will be the reduction in unemployment Again assume the relationship is linear (4) dU/dt = – k3U(1 – k4I) = – k3U + k3 k4IU To simplify the mathematics, assume k1k2 = k3k4 = k5 (2’) dI/dt = k1I – k5IU (4’) dU/dt = k5UI – k3U Equations (2’) and (4’) are the equations generated by the Lotka-Volterra model, used in ecological modeling The most common use of this model is the predator/prey relationship, in which I represents the number of prey and U represents the number of predators Left to itself, the prey population increases at a given rate, k1 (equation 1) But the prey population also decreases by some fraction, k1k2, of the number of predator-prey encounters (equation 2) Predators, left to themselves, lack adequate nutrition and their population declines at the rate k3 (equation 3) Thanks, however, to the nutrition provided by the prey, the predator population increases by some fraction, k3k4, of the number of predator-prey encounters (equation 4) The steady-state solution to equations (2’) and (4’), in which both inflation and unemployment are permanently fixed at their initial values, is (5) I0 = k3/k5; U0 = k1/k5 Greater insight comes from considering what happens if inflation and unemployment are displaced from their steady state values Set (6) I(t) = I0 + Ieωt; U(t) = U0 + Ueωt where (6a) |I/I0| « 1; |U/U0| « Insert equation (6) into equations (2’) and (4’), neglecting higher order terms in I and U This generates the dispersion equation: (7) ω2 + k1k3 = In the inflation-unemployment example both k1 and k3 are positive, yielding stable orbits that describe ellipses around the steady state point (I0,U0) (8) I(t) = I0 + Iei( k1k3 )t; U(t) = U0 + Uei( k1k3 )t 116 Appendix Higher inflation (I↑) → monetary and fiscal restraint → slower growth → higher unemployment (U↑) → less demand → lower inflation (I↓) → monetary and fiscal stimulus → faster growth → lower unemployment (U↓) → greater demand → higher inflation (I↑)… Despite the failure of this example to capture the full range of nonlinear behavior and despite its oversimplified assumptions, it captures the rotational, cyclic, aspect of the Phillips curve, an aspect that often goes unnoticed (Where each year represents a point on the I–U curve, the line connecting consecutive points is characterized by a persistent clockwise rotation.) This provides a glimpse of one mechanism that generates economic cyclicality Slightly more complex assumptions yield a broader range of nonlinear behavior In a second example, consider the velocity of money (V) and the rate of inflation (I) If there is no inflation, assume the velocity of money will asymptotically approach some limit, V0 Assume the rate of change in V is proportional to the difference between the actual velocity of money and its ultimate zero-inflation limit, V0 (9) dV/dt = k(V0 – V) If there is inflation, then inflationary psychology (Ψ) will lead people to spend more quickly and to borrow more and save less The velocity of money will increase This provides a positive feedback mechanism Higher inflation → greater inflationary psychology → a higher velocity of money → still higher inflation Choose a measure of inflationary psychology such that the relationship between inflation and inflationary psychology is linear (Ψ ∝ I) Assume the relationship between this measure of inflationary psychology and the velocity of money is quadratic (Ψ ∝ V2) (10) dV/dt = k(V0 – V) + k1Ψ = k(V0 – V) + k1V2I = k1 (A +V2I – BV – V/k1) where A = kV0/k1 and B = (k – 1)/k1 Now consider the change in inflation If there is minimal inflation initially, monetary accommodation will cause inflation to increase Assume the higher the velocity of money, the greater the sensitivity of the system and the greater the change in inflation Assume the relationship is linear (11) dI/dt = k2V To the extent that there is noticeable inflation, restrictive monetary policies will increase interest rates and dampen the rate of inflation Assume the degree of tightening (T) is proportional to both the rate of inflation and the 117 Myths of the Free Market velocity of money (T = k5VI) Also assume that the (negative) change in inflation is proportional both to the degree of tightening and the velocity of money: (dI/dt = –k6TV = – k5k6V2I) (12) dI/dt = k2V – k3V2I = k3 (CV – V2I) where k3 = k5 k6 and C = k2/k3 To simplify the mathematics, assume k1 = k3 = 1, and B = C (10’) dV/dt = A +V2I – BV – V (12’) dI/dt = BV – V2I Equations (10’) and (12’) embody a model developed by Prigogine and Nicolis, called the Brusselator This model has been successful in explaining a wide range of cyclic behaviors in chemistry and biology From equations (10’) and (12’) the steady state is (13) V0 = A; I0 = B/A We get the time-dependent solutions for V(t) and I(t) by treating these equations like the Lotka-Volterra equations, (2’) and (4’) The dispersion equation is: (14) ω2 + (A2 – B + 1)ω + A2 = Provided B › + A2, the real parts of ω are positive This generates true instability and a limit cycle The steady state is not stable If the system is displaced even the smallest distance from the steady state, it moves further away from that steady state It eventually rotates around it in a closed curve at an angle to the Cartesian coordinates that — significantly — is independent of its initial displacement A system that has been barely displaced from its steady state will, in time, behave exactly like a system that started far from the steady state Qualitatively, increasing inflation leads to greater monetary restraint This raises interest rates enough to reduce spending and lower the velocity of money But it takes time for inflation to subside Inflation has its own momentum, and prices continue to rise even in the face of a slowing economy and increasing inventories When inventories rise past a certain level, they exert downward pressure on prices Inflation eventually subsides Then, after inflation and the velocity of money have been declining for some time, with inflationary psychology drained from the system, a new round of monetary accommodation lowers interest rates Economic growth and the velocity of money increase But with an overhang of inventory still to be worked off, sellers are in no hurry to raise prices So there is a time lag before this increased velocity of money translates into higher price levels Eventually, a new inflation cycle begins 118 Appendix This explains why inflation is a lagging indicator It also shows that exogenous shocks to the economy are not necessary to generate business cycles The smallest internal fluctuation, which need not be generated by any external event, gives rise to the same cycles as if one had started with the random exogenous shocks postulated by modern business cycle theorists Adding just one more element of complexity opens the door to a wider variety of nonlinear phenomena Suppose we include a diffusion term (corresponding to the trickle-down effect in economics) in the Brusselator (15) dV/dt = A + V2I – BV – V + DV∂2V/∂r2 (16) dI/dt = BV – V2I + DI∂2I/∂r2 where DV and DI are constants for the rates of diffusion of V and I Now the system can act in new ways As the value of B increases beyond particular constants, called bifurcation points, new solutions appear to equations (15) and (16), triggering a variety of new behaviors Among the solutions to these equations one can find (i) non-uniform steady states, spatially periodic, in which different points have different, but unchanging, values of V and I; (ii) limit cycles, discussed in the previous example (obtained whenever DV = DI = 0); and (iii) economic waves propagating across the system without damping In none of these cases does the system tend to any uniform stable state Note how radically different is this picture of the behavior of nonlinear systems from the classical picture of quiescent uniform steady states Even in thermodynamics, chemistry and biology non-uniformity and cyclic change are natural behaviors underlying persistent structures A quiescent uniform steady state is unstable at the micro-level and cannot persist Any fluctuation away from that steady state will be amplified and will lead the system further away And the system will not return to that steady state Even for simple systems in the natural sciences it is impossible to remain in an unchanging steady state Consider how different is this picture of natural behavior from the standard picture of stable quiescent equilibrium that prevailed in the days of Adam Smith Imagine how economic theory might have developed had the nonlinear paradigm been available in those days Given the progress we have made in understanding open systems in the natural sciences — and economies are open systems — would it not be appropriate to re-examine economic theory in the light of this progress? For it is plausible that there are aspects of economies whose evolution can be described by differential equations similar to those above This makes it plausible that there is economic behavior that parallels the nonlinear chemical 119 Myths of the Free Market and biological behavior investigated by Prigogine and his colleagues It calls attention to the possibility that successful endeavors to explain the economic counterparts to this chemical behavior will draw attention to “new” economic phenomena, phenomena that have hitherto gone unnoticed because they not fit the traditional paradigm 120 POLITY VALUES, SCIENCE, REASON “Nothing is more dangerous than an idea, when it is the only one we have” (Émile A Chartier) Despite its manifest shortcomings even within economics, the non-interference philosophy of the free market has done much to shape our attitudes in areas ranging from politics to education If we are not blinded by the false mystique of laissez faire, we may be open to alternative perspectives Acknowledging the possibility of valuable worldviews and priorities beyond those of the free market, we may look at society through the eyes of other disciplines For we have made significant progress in the social sciences as well as the natural sciences Even in value theory, regarded by many as the academic discipline least likely to break new ground, we have advanced This progress can serve as a general guide to addressing difficult open-ended issues Consider the right to life case, which has rested on the following argument: (i) Every person has the right to life (ii) The fetus is a person (iii) Therefore, the fetus has the right to life (iv) The fetus requires the mother’s womb to exercise that right to life (v) Therefore, the fetus has the right to the mother’s womb (vi) Although the mother may have the right to her own body, the right to life outweighs the right to decide what happens to one’s body (vii) It is always wrong to invert these moral priorities, to take the mother’s right to decide what happens to her body as more important than the fetus’s right to life 123 ... dampen the rate of inflation Assume the degree of tightening (T) is proportional to both the rate of inflation and the 117 Myths of the Free Market velocity of money (T = k5VI) Also assume that the. .. Zen-like sense of … insignificance in the face of the Market. ” (Millman, The Day Trader, p 25. ) The diversity of failures of the free market should suffice to reject theological laissez faire Flaws... not in profundity to that of Thomas Aquinas or Karl Barth As I tried to follow the arguments and explanation of 99 Myths of the Free Market the economist-theologians who justify The Market? ??s